Goldman Sachs Gets Into The Loan Business

With record low interest rates and dwindling opportunities in the mainstream credit markets, venerable investment bank Goldman Sachs (NYSE:GS) has begun the process of listing its new business development company (BDC) subsidiary- the Goldman Sachs Liberty Harbor Capital fund- to individual investors.

While originally created with the “dubious” distinction of allowing Goldman to keep a hand in the credit business despite new constraints and regulation hassles expected to come with the final implementation of the Volcker Rule, the new BDC does some light on a somewhat traditionally sleepy and often ignored sector.

Public Private Equity
When a giant corporation like Procter & Gamble (NYSE:PG) needs to raise capital, it can go to any investment bank and offer bonds to the investing public. Likewise, when your local neighborhood coffee shop needs to buy a new espresso machine, it can walk into a bank branch and get a loan. But for those companies in the middle-market, finding credit for expansion can be difficult. That's where business development companies (BDC) come in. BDC's invest in or lend to small- to midsized companies and provide managerial assistance in hopes of profiting as these businesses grow.

It’s quite a lucrative business as the debt BDCs provide can generate yields of 10% or more depending on the type of loans. For example, subordinated debt and mezzanine loans often carry higher rates. Much of this yield is kicked back to shareholders. Like real estate investment trusts (REITs), BDCs are not taxed at the corporate level as long as they pay out to shareholders at least 90% of their taxable annual net income each year. Adding in the slight leverage they are allowed to use and that can provide some juicy dividends. Industry stalwarts like Ares Capital (NASDAQ:ARCC) and Apollo Investment Corporation (NASDAQ:AINV) yield in the 6 to 10% range.

For Goldman, however, the appeal may be more than just providing capital to small- and mid-sized businesses and collecting a dividend, which is what makes its BDC a little more dangerous.

Under the Volcker Rule, curbs are placed on banks sponsoring investment funds. The new BDC vehicle will be launched via the bank's Liberty Harbor unit. That group runs a series of credit-focused hedge funds. According to the Financial Times, Goldman might have been forced to shut the unit down if it did not list Liberty Harbor as a BDC because of the Volcker rule. BDCs aren’t subject to the same sort of regulation, and some analysts predict that the move is less about providing financing to small companies and more about trading debt securities to make a profit. The basic fear is that Goldman is really just doing this to skirt the regulations.

Skip It
While it may be tempting to bet with the investment bank when the company finally launches, the truth is Liberty Harbor won’t be like a “real” BDC. Given Goldman’s history- and wording directly in the IPO filing- there’s plenty of shenanigans to be had. That means skipping it if you get the chance to buy it in the IPO process or right after on the secondary market.

However, that doesn’t mean the sector should be off limits as there are plenty of BDC firms that are doing right by shareholders.

One such BDC with a long history of providing for shareholders is Hercules Technology Growth Capital (NYSE:HTGC). The managers at have done a good job of identifying the next big things. Previous investments have included online real estate database Trulia (NYSE:TRLA), LED equipment maker Rubicon Technology (NASDAQ:RBCN) and biotech Aegerion Pharmaceuticals (NASDAQ:AEGR). This previous successful exit event along with HTGC current loans help support the firm’s cash flows and its juicy 8.5% dividend. With cleantech, social media and cloud computing giving the technology sector a major rebirth, investors may want to focus their BDC efforts there.

Or for those wanting to own a wide swath of the industry, the new Market Vectors BDC Income ETF (ARCA:BIZD) or the UBS E-TRACS Wells Fargo Bus Development Company ETN (ARCA:BDCS) can be used to gain access to the sector as a whole.

The Bottom Line
Goldman Sachs’ recent decision to list a piece of Liberty Harbor Capital subsidiary as a BDC may look good at first blush, but things may not be all it’s cracked up to be. However, the business development sector does offer plenty of other quality dividend paying firms that could belong in your portfolio. Hercules Technology Growth Capital is just one example.

At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.